Net Present Value (NPV) Method Versus Internal Rate of Return (IRR) Method:

Learning Objectives:

1. What is the difference between net present value (NPV) method and internal rate of return (IRR) method?

The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method. First the net present value method is often simpler to use. As mentioned earlier, the internal rate of return method may require hunting for the discount rate that results in a net present value of zero. This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer spreadsheet.

Second, a key assumption made by the internal rate of return (IRR) method is questionable. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return is the internal rate of return on the project. Specifically, it the internal rate of return of the project is high, this assumption may not be realistic. It is generally more realistic to assume that cash inflows can be reinvested at a rate of return equal to the discount rate - particularly if the discount rate is the company's cost of capital or an opportunity rate of return. For example, if the discount rate is the company's cost of capital, this rate of return can be actually realized by paying off the company's creditors and buying back the company's stock with cash flows from the project. In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method. Of the two methods, it makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

 

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